Australasian Accounting, Business and Finance

Journal
Volume 11
Issue 4 The Growth Game Changer: How Accounting Article 6
Works in the Digital Era

The Influence of Pseudo Auditor Rotation on Audit

Quality: New Evidence
Rahmat Febrianto
Andalas University, Indonesia., febrianto.rahmat@gmail.com

Fitria Dini
Andalas University, Indonesia.

Dela Audina
Andalas University, Indonesia.

Yuskar Yuskar
Andalas University, Indonesia.

Verni Juita
Andalas University, Indonesia.

Follow this and additional works at: http://ro.uow.edu.au/aabfj

Copyright ©2017 Australasian Accounting Business and Finance Journal and Authors.

Recommended Citation
Febrianto, Rahmat; Dini, Fitria; Audina, Dela; Yuskar, Yuskar; and Juita, Verni, The Influence of
Pseudo Auditor Rotation on Audit Quality: New Evidence, Australasian Accounting, Business and
Finance Journal, 11(4), 2017, 71-85. doi:10.14453/aabfj.v11i4.6

Research Online is the open access institutional repository for the University of Wollongong. For further information contact the UOW Library:
research-pubs@uow.edu.au
The Influence of Pseudo Auditor Rotation on Audit Quality: New
Evidence
Abstract
The objectives of this research are twofold, to test the audit quality of companies that change their auditors
either voluntarily or mandatorily and to test the financial characteristics as a factor for an accounting firm to
engage in pseudo mandatory rotation. Since 2002, Indonesia has had legislation mandating companies to
rotate their auditor after six years of consecutive engagements (five years prior to 2008). However, auditors
sometimes seem to find their own way to deceive the mandatory regulation by a tactic called “pseudo”
mandatory rotation. Thus, we divide mandatory rotation into two categories, pure and pseudo mandatory
rotation.

The results of the data we collected since the Ministerial decree became effective in 2003 indicate companies
that rotate their auditors mandatorily have higher audit quality than that of companies voluntarily rotating
auditors. However, we cannot find evidence that pseudo and pure mandatory rotation have different audit
qualities. The results also indicate that switching among bigger accounting firms have the highest audit quality
rather than switching between smaller audit firms which have lower audit quality. Lastly, the motives of an
accounting firm to engage in pseudo or pure mandatory rotation are related to the financial size of their
clients. Future research must consider the limitation stated in this study.

Keywords
audit quality, auditor switching, discretionary accruals, pseudo and pure mandatory rotation, voluntary
rotation, Indonesia

This article is available in Australasian Accounting, Business and Finance Journal: http://ro.uow.edu.au/aabfj/vol11/iss4/6
 The Influence of Pseudo
Auditor Rotation on Audit Quality:
New Evidence
 

Rahmat Febrianto1, Fitria Dini2, Dela Audina3, Yuskar Yuskar4 and Verni Juita5

Abstract
The objectives of this research are twofold, to test the audit quality of companies that change
their auditors either voluntarily or mandatorily and to test the financial characteristics as a factor
for an accounting firm to engage in pseudo mandatory rotation. Since 2002, Indonesia has had
legislation mandating companies to rotate their auditor after six years of consecutive
engagements (five years prior to 2008). However, auditors sometimes seem to find their own
way to deceive the mandatory regulation by a tactic called “pseudo” mandatory rotation. Thus,
we divide mandatory rotation into two categories, pure and pseudo mandatory rotation.
The results of the data we collected since the Ministerial decree became effective in 2003
indicate companies that rotate their auditors mandatorily have higher audit quality than that of
companies voluntarily rotating auditors. However, we cannot find evidence that pseudo and pure
mandatory rotation have different audit qualities. The results also indicate that switching among
bigger accounting firms have the highest audit quality rather than switching between smaller
audit firms which have lower audit quality. Lastly, the motives of an accounting firm to engage
in pseudo or pure mandatory rotation are related to the financial size of their clients. Future
research must consider the limitation stated in this study.6

JEL Classification: G38, M42, L51.

Keywords: audit quality, auditor switching, discretionary accruals, pseudo and pure mandatory
rotation, voluntary rotation.
                                                                 
1
Andalas University, Indonesia.
2
Andalas University, Indonesia.
3
Andalas University, Indonesia.
4
Andalas University, Indonesia.
5
Andalas University, Indonesia.
6
This research was funded by the Andalas University. We thank the attendees of The 6th International Accounting
Conference in Yogyakarta for their helpful comments.
AABFJ | Volume 11, no. 4, 2017 

INTRODUCTION
Indonesia is one among few countries that mandates auditor rotation7. The regulation of auditor
rotation has been enacted since 2002 and is still in effect until today8. The enactment of this
regulation has some implications on research and raises debate between regulators and
academicians. The debate questions which one is better among these polar opposites, whether to
regulate or not to.
The investigation of the effect of mandatory auditor rotation outside Indonesia are rarely
studied. This is caused by the fact that not many countries have such regulation. For example, a
study in South Korea conducted by Kwon et al. (2014) indicates that the audit quality did not
change there. Meanwhile, investigation from other perspective conducted by Cameran et al.
(2015) shows that replaced auditor (or in its final year before rotation) does not decrease its audit
quality. However, the audit fee is raised by 7% compared to previous years. On the contrary, this
investigation found an indication of lowballing (as low as 17%) is raised abnormally in later
years by the replacing auditor in the first year of its tenure. In relation to the audit quality, they
found evidence of lower audit quality during the first three years of engagements before being
raised into higher tenure.
Several studies have investigated the importance of mandatory auditor rotation in
Indonesia. Febrianto & Sugiri (2014) for example, fail to find changes in audit quality of firms
that rotated their auditors. Another research with similar conclusion was drawn by Siregar et al.
(2011), earlier than the research above. Both studies were tested from 2002-2008 or during first
rotation in which the latter rotation may be untouched.
Febrianto & Sugiri (2014) invited other researchers to investigate audit quality of more
rotating firms further. They believe that some of the auditees are still audited by the same
accounting firm before and after the mandatory rotation. This indication can be seen from
foreign affiliation that local accounting firm has. If pre-rotation and post-rotation were audited
by the same auditor, the increase in audit quality being aimed will be an empirical question to
answer then. Febrianto & Sugiri (2014), Siregar et al. (2011), as well as Junaidi et al. (2014) call
this type of auditor rotation as pseudo mandatory rotation.

Research Importance
This research is important based on several reasons. First, the regulation of mandatory auditor
rotation is unique and can only be found in few countries outside Indonesia. The US government
has launched several tactics to have supports regulating accounting firm rotation but
academicians come out with evidence contrary to government’s expectation. Therefore, people
are still interested to answer whether this requirement may have some effect on audit quality or
not. Second, some Indonesian local accounting firms have agreed to change their local identity
but still maintain their foreign affiliation. This motivation may be related to maintaining one or
more important clients which have deep pockets. Siregar et al. (2011), Febrianto & Sugiri
(2014), and Junaidi et al. (2014) all find some indications of this motivation. Therefore, the
                                                                 
7
Other countries that also mandate auditor rotation are Italia and South Korea. Italia has enacted the regulation since
1975 (Cameran et al., 2015). European Union has also considered it even though it is still not enacted. South Korea
mandates auditor rotation during 2006-2010 (Kwon et al. 2014). Other countries that mandate auditor rotation are
Brazil and Singapore—only for banks (Kwon et al., 2014).
8
Current regulation is Ministry Regulation Decree No. 17/2008. This decree replaces decree No. 423/2002. Later
the Presidential decree No. 20/2015 also regulates auditor rotation. However, Article 11 of that decreee only
regulates a partner tenure in a client, not the CPA firm’s tenure. So, ministrial decree No. 17/2008 is still relevant.

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regulator must be interested in the reasons why some accounting firms desperately wanted to
keep their clients and managed to find loopholes in the regulation. This raised several questions
such as what motivates the accounting firm to do so, who the client is, and what power it has on
the auditor. No study so far has addressed this question yet.

Research Contribution
The results of this study will provide additional evidence for Indonesian government, as well
other countries’, with the advantages of mandatory auditor rotation regulation. Some studies
have been conducted set in Indonesia to study the impact of this regulation on audit quality. The
results are still inclonclusive and bring some debates since some accounting firms find the
loopholes so that they can retain their clients longer than the regulation have allowed.
The results of this study will also be beneficial to academic communities as a whole since
studies on the impact of this regulation can only be done in a country that has regulated
mandatory auditor rotation. While the US government is eager to regulate firm-level rotation,
public in the US have divided opinion related to such regulation. Therefore, the results will be
beneficial to much larger communities in the world. Lastly, the conclusion on the characteristics
of companies that are retained by their auditors can also be beneficial to the regulator by
exploiting the loopholes in the regulation. They can assess the impact of the loopholes later on
the idea of maintaining higher audit quality. Empirical evidence found in this research can also
be used as a base to be considered in future regulation.

THEORETICAL FRAMEWORK AND HYPOTHESES DEVELOPMENT

Voluntary vs. Mandatory Auditor Rotation

The idea of whether to apply mandatory rotation to accounting firm is more necessary or to let
the client and auditor decide their tenure are still debated in the US. Regulator thinks that the
tenure in audit industry must be regulated, while some academicians oppose the idea. The basic
issue here is how to maintain the auditor’s independence. The regulator and some academicians
believe the auditor’s independence is declined if the tenure is not limited. The logic flows that
the longer the tenure and the more income the auditor depends on the client, the more declining
its independence.
Some practioners and academicians disagree with the idea on the negative relationship
between auditor’s independence with auditor tenure. DeFond & Francis (2005:9) stated that the
incidence of audit failures are almost zero. Similar to them, the auditing professions opined that
every time the auditor is engaged with a new client, there are two costs that must be considered:
(1) cost that relates to study and comprehend client’s business and (2) litigation cost. Both costs
are interrelated which the auditor is responsible for such unlawful action of their client since the
financial report is joint product of both auditor and the client (Kinney, 1999).
The criticism that public poses againts the idea of mandatory rotation is related to the logic
behind the imposition to switch the auditor. They believe that the business is better off if the
government let the auditor and its client to decide their own tenure, and the government does not
have to step in. They also believe that a longer tenure is related to more understanding on client’s
business, lower probabilities of client to commit in fraudulent action, lower audit risk, and more
benefits (see DeFond & Francis, 2005 for detail discussion).

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Bockus & Gigler (1998) argue that auditor will likely to withdraw if the risk they face in
auditing a client is increased. The risk may be a result of both party disagreed on a certain
accounting estimate. Antle & Nalebuff (1991) and Dye (1991) propose that auditor’s proposition
will be accepted by the client if auditor’s estimates are close to that of client’s. If they never met
an agreement on that such estimates, we can predict that client will fire the auditor or, else, the
auditor will resign (Dye, 1991).
However, the scenario above is only true if both auditor and client are free to decide their
own engagement. In a regime where a law decides an auditor must be replaced, the auditor
switching is not due to the disagreement between both party but it is caused by the regulation
that decide their separation and the client finds a new auditor. The new auditor may have a little
information on this client’s reputation and business. Therefore, it is expected that the new auditor
will put more skepticism on this engagement.
A higher level of skepticism has two opposite sides. First, it will raise audit fee since
auditor has to bear a higher audit start-up cost. If an auditor is replaced with a new one, the new
auditor has no guarantee for next year’s service since the regulation itself permits the client to
come back to the previous one. Since the probability to retain the client is slim, then the audit fee
imposed on the new client may be higher than on the normal first time engagement. The
lowballing phenomenon addressed by DeAngelo (1981) may not be surfaced since the new
auditor does not expect the client will retain them as long as the regulation permits.
The other side of a higher level of skepticism is related to auditor’s prudence in auditing
new client. If the auditor does not know its client’s business or its reputation in the past, the
auditor will be more careful to audit this new client. The more prudence the auditor, the lower
the litigation cost. Nagy (2005) shows that auditors of ex-Andersen’s clients become more
conservative in choosing accounting methods that decrease the income. This action is triggered
by perception that ex-Andersen’s clients bear more risks (Cahan & Zhang, 2006). The
proponents of mandatory auditor rotation argue that the regulation will bring higher audit quality
because regularly the auditor will face new client.

Auditor Rotation Regulation in Indonesia

Indonesia is among few countries that mandates both partner and accounting firm rotation. This
regulation was first enacted in 2002 through the Ministry of Finance decree No. 423. Article 6
verses 4 of the decree stated that an accounting firm may only provide a general audit up to to
five consecutive years, while a partner may only lead an audit for three consecutive years in a
single client. Later in Article 59 verses 5 and 6 stated that the accounting firm or the partner may
still provide the service for one more year if they have signed a contract with their clients for
another year. This 2002 decree was then amended in 2003 and finally in 2008. In the last decree,
the accounting firm can audit a client up to six consecutive years and after one cooling off year
the auditor can re-engage with the same client.
This decree has several implications to the research in auditing. First, this creates some
space for research in mandatory auditor rotation, either partner or accounting firm, which most
other country cannot test. Second, until the year 2016, mandatory rotations have been conducted
by companies in Indonesia at least two times. Therefore, if Siregar et al. (2011), Febrianto &
Sugiri (2014), and Junaidi et al. (2014) can only observe single rotation, by the year 2014/2015
more data are already available.
Third, MOF decree No. 17/2008 opens an opportunity for a client to re-engage with
former auditor after one year being “parked” by another auditor. The other tactic that may be

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 Febrianto, Dini, Audina, Yuskar & Juita | The Influence of Pseudo Auditor Rotation on Audit Quality
 

exploited is what so called pseudo auditor rotation (Siregar et al., 2011; Febrianto & Sugiri,
2014; and Junaidi et al., 2014). There are two loopholes to exploit from the Article 3 verses 5
and 6 of MOF decree. One, if an accounting firm change the composition of their CPAs and only
keep less than 50% of them, then the new accounting firm is different from the former; or, two, if
the company changes its name and only maintains less than 50% of the former CPAs in the new
firm, then the new accounting is recognized as different from the former.9 Luckily, the regulation
is silenced on the foreign affiliation, so even though a client is said to change its local auditor,
the foreign affiliation retains the same, and even situated at the same office address.
The question that may quickly follow is whether this behavior will decrease the quality of
audit or not. Nagy (2005) is one of many that disagrees with the idea of mandatory rotation. He
provided evidence of a higher skepticism exercised by auditors of ex-Andersen clients. He takes
it as an example of a mandatory rotation—while in fact it is not. Later Knechel & Vanstraelen
(2007) provided evidence that may contradict to Nagy’s (2005). They show that low audit
quality in a shorter term tenure is more likely to be caused by either lack competence or lack of
independency. Moreover, the low audit quality in a longer tenure period may due to the loss of
independency. Their results reject a claim made by Carcello & Nagy (2004) that audit failures
observed in the first years of engagements are caused by problems on the client’s side. Their
results showing the fact that happened are on the opposite.
Some studies are not supportive to the idea that audit quality will be increased after the
rotation. Johnson et al. (2002) found evidence that auditors with short tenure (2-3 years) show a
higher level of unexpected accrual as compared to auditors with medium tenure (4-8 years).
Moreover, samples that have longer tenure (>9 years) do not show a statistically significant
difference to samples with medium tenure. Myers et al. (2003) concluded that longer auditor
tenure is correlated with higher earnings quality. They argue that there is no evidence to support
the claim that mandatory rotation can increase financial reporting quality.
However, there is a study that does support the mandatory rotation idea. Dopuch et al.
(2001) clearly have the evidence that auditors exhibit lower judgment bias when they are in a
mandatory rotation regime than when they are in voluntary rotation regime. Considering the
conclusions that Dopuch et al. (2001) have, studies that do not support the mandatory rotation
idea, e.g. DeFond & Francis (2005), are failed to quote Dopuch et al.’s (2001) study. The
importance of their study is significant and their study should be published on post-Enron
debacle and post-SOX. Like Dopuch et al. (2001), Carey & Simnett (2006) conclude that there is
a decline in audit quality which has longer audit partner’s tenure.
To summarize, hipothetically, auditors will show different behavior if they are in different
circumstances, in this case, whether they are in a mandatory or voluntary rotation regime. This is
logical since the essence of a rotation is to limit, if not to cut, the dependency of the auditors to
their client. The absence of rotation regulation will be functioned as an incentive to auditors to
retain their clients as long as possible. The longer the tenure, the more income will flow to the
accounting firm from a certain client and the higher the probability the auditors to be dependent
financially from their clients. Certainly, it cannot be said that an auditor become financially
dependent on a certain client; and perhaps it never be. However, it is theoretically logical that
mandatory rotation can cut the likelihood of an auditor to be dependent on its client. Therefore,
we can expect that audit quality is higher in companies that rotate their auditors mandatorily than
in companies that rotate their auditors voluntarily. The first hypothesis is below.

                                                                 
9
 For our study purpose, we call this as dissolve and reform strategy. 

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H1 Audit quality of companies that rotate their auditors mandatorily is

higher than companies that rotate voluntarily.
Related to the loopholes found in the MOF decree, it can be concluded that the loopholes in that
decree are exploited by the accounting firms and their clients to create a pseudo mandatory
auditor rotation. This pseudo rotation phenomenon is clearly contradicted to the regulator’s idea
that rotation is needed to preserve audit quality. If an auditor agrees to take advantage of the
loopholes available in the Article 3 verses 5 and 6 of that MOF decree for the sake of retaining
certain client(s), then it can be expected that the auditor’s independency on that client is lower
than other client that is audited by the same auditor. Likewise, the audit quality of retained client
is also lower than clients of other auditors that do not exploit the regulation’s loopholes. The
second hypothesis is as follows:

H2 Audit quality of companies that pseudo-mandatorily rotated their

auditors are lower than companies that mandatorily rotated their
auditors.

The third hypothesis is based on the idea that bigger accounting firms will deliver higher audit
quality than that of smaller ones (for example see DeAngelo, 1981). The idea may hold if a client
switches accounting firms of different and similar size. We may expect using the argument that
bigger accounting firms have higher quality than that of smaller one. The audit quality among
firms switching from bigger to bigger and from smaller to smaller accounting firms will be
equal. While on the contrary, switching among firms of different size will be unequal.

H3 Audit quality of companies that switch auditors between bigger

accounting firms is different than that of that switch from auditor of
different size, i.e. the one that switches between bigger accounting firms
has the highest audit quality.

The Characteristics of Pure and Pseudo-Rotating Companies

If the auditor only has one or several years of tenure with a client, the accumulative fees received
from that client may not be as significant as total income of the auditor. However, as the tenure
gets longer and more services rendered, it is not impossible for the auditor to compromise its
independency. The bigger the client is, more probability of such behavior will occur. In fear of
losing big pocket clients, auditor will find a way to retain them.
The problem on the dependency is very much related to the ratio between the number of
accounting firms and auditees. The competition is stiff among accounting firms while the market
is relatively small and does not grow. Since the quality among accounting firms differs each
other, clients will always find an auditor with a good quality. The quality is not always the factor
of consideration. Clients actually will find an auditor that suits their needs. In sum, it is natural to
expect a close relationship between auditor and its client and this relationship will last as long as
possible.
If the auditor has a long relationship with its client while regulation prohibits this,
resistance will emerge. This resistance may not always be in the form of refusal of the regulation
since the regulation may have some loopholes and auditor can exploit them. Regarding this MOF
decree, pseudo-mandatory rotation is the manifestation of this resistance.

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The question is, how important is a client to an auditor so that the CPA firm agrees to
dismiss more than 50% of its CPAs and form a new firm; or dismiss the firm itself and form a
new one while only maintain not more than 50% of old CPAs? The client company that force the
accounting firm to take the advantage of the loopholes must be significantly different from any
other companies. Therefore, the third hypothesis as follows:

H4 Characteristics of companies that pseudo-mandatorily rotated their

auditors are different from companies that pure mandatorily rotated
their auditors.

RESEARCH METHOD

Samples
PMK (MOF decree) No. 17/2008 is a follow-up regulation of KMK No. 423/2002. In this regard,
the selection of the sampling companies that conducted the mandatory and voluntary rotation of
auditor is determined by the observation on auditor switch which has occurred since 2003. The
determination of whether a rotation or changing of the auditor in 2003—or at the latest in
200410—was a mandatory rotation or not has to be conducted through the observation of auditors
within the last five years before the rotation year. The replacement of auditor occurred in 2003
(or 2004) is called as a mandatory rotation if since 2002 (or 2003) a client has been audited by
the same auditor for five consecutive years. Otherwise, if the audit period is less than five years,
it can be called a voluntary rotation. The same procedure would be applied to the observation of
the replacement of auditor occurred after the enactment of PMK 17/2008.11 The samples are
selected from the nonfinancial companies listed on the Indonesia Stock Exchange (IDX) from
2002 to 2015. For the case of newly listed firms in IDX, they have to be, at least, already six-
year-old when the observation year is started.

Definition of Opertional Variables and Hypotheses Testings

Hypothesis 1, 2 and 3
Following Becker et al. (1998), DeFond & Subramanyam (1998), Bartov et al. (2000)
and Nagy (2005), this study uses discretionary accrual as a proxy for audit quality.12 The
discretionary accrual is estimated by using the Jones’ model that was modified by DeFond &
Jiambalvo (1994) and DeFond & Subramanyam (1998). This study uses the following model to
estimate the discretionary accrual.
, ∆
∝ (1)
, , , ,
where:
TAi,t = accrual total of firm i in year t;
Ai,t-1 = total assets of firm i in year t-1;

                                                                 
10
KMK (MOF decree) No. 359/2003 permits audited company to be audited by the same auditor even though the
five years limitation has been reached if the company and its auditor have already signed an agreement to audit in
2003.
11
After 2008, mandatory rotation is after six years. 
12
Interested readers can consult with Krishnan (2003) to follow the logic behind the use discretionary accruals as a
proxy for audit quality.

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AABFJ | Volume 11, no. 4, 2017 

∆REVt = net change in income of firm i in year t;

PPEi,t = gross value of PPE of firm i in year t; and
ɛi = error term.
The discretionary accrual is the errors aforementioned above (DeFond & Subramanyam,
1998; Francis & Yu, 2009). This study uses an absolute unstandardized residual as a proxy for
discretionary accrual. Later, that discretionary accrual value is incorporated into the following
equation below:

, , , , , (2)

Where:
AbsURi = cross-sectional absolute value of the unstandardized residual of firm i;
DROTi,t = dummy variable: 1 for the auditor mandatory rotation, 0 others;
Pseudoi,t = dummy variable: 1 if the auditor rotation is pseudo-mandatory, 0 if others;
DBBi,t = dummy variable: 1 if the auditor rotation occur among Big 4, 0 if others;
DBKi,t = dummy variable: 1 if the auditor rotation occur from Big 4 to the smaller
accounting firms, 0 if others;
DKBi,t = dummy variable: 1 the auditor rotation occur from the smaller accounting firms to
Big 4, 0 if others;
θi = error terms.
Equation (2) is used for testing the first to the third hypothesis. The first hypothesis is
accepted if coefficient b1 is statistically different from zero. Likewise, the second hypothesis is
accepted if coefficient b2 is statistically different from zero. Meanwhile, coefficients b3 to b5,
which are testing the hypothesis four, are used to assess the differences between accounting
firms of different sizes.

Hypothesis 4
The fourth hypothesis tests the differences between firms that implement pseudo-mandatory
rotation and firms that implement the pure mandatory rotation. The regulation of mandatory
rotation is made in order to ensure the high level of independency exercised. If an accounting
firm is willing to utilize the regulatory loopholes by retaining a certain client, we can expect that
the retained client has different characteristics compared to those who are not being retained.
Therefore, the testing of the fourth hypothesis is the testing in the difference of the two group
companies’ characteristics.
The point of observation is when an accounting firm changes its name (including the
personnel of public accountants/CPAs) and continuously retains the client after the sixth year.
This is possible since changing name does not violate the Article 3 verse 4 and 5 of decree
No.17/2008. According to the Article, the client “X” has already been considered changing its
auditor in seventh year to the auditor “B”, alias “A”.
One of the most relevant company’s characteristics that encourage accounting firms to
change their name is the amount of auditing fee received from the clients. However, the data on
auditing fee is not available in Indonesia. An auditing fee can be represented by the company's
asset value or market capitalization or other financial characteristics. The hypothesis is being
tested by comparing the two groups’ characteristics on the year of the rotation.

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Results
We divide our analysis into two sections. Section one is for the first two hypotheses tests’ results
and section two is for the fourth hypothesis. Furthermore, as readers can find in the descriptive
statistics subsection, both sections have different final samples due to the different requirements
in sampling procedures.

First, second, and third hypotheses

Samples are non-financial companies listed from 2003 to 2015. We check auditor of each
samples as far as 1998 to 2003. Sampling criteria are also based on the regression models (1) and
(2). The resulting samples are as in Table 1 below.

Table 1: Samples
Description Number
Nonfinancial samples-companies listed 1998-2015 3978
Nonfinancial samples-companies listed 1998-2001 (884)
Samples that do not perform audit rotation in 2002 – 2015 (1747)
Incomplete data in 2002-2015 (490)
Total samples-companies 857

Descriptive statistics are presented below.

Table 2: Descriptive Statistics (N=857)

Modus
Variables Minimum Maximum Mean Std. Deviation
(freq)
ABSUR 0.00019 5.09270 0.12777 n.a 0.28930
DROT 0 1 0.17 0 (714) 0.372
PSEUDO 0 1 0.06 0 (804) 0.241
DBB 0 1 0.34 0 (506) 0.474
DBK 0 1 0.07 0 (795) 0.259
DKB 0 1 0.09 0 (782) 0.281

Table 2 shows the minimum and maximum value of ABSUR which are 0.00019 and
5.09270. Higher residual indicates higher earnings management or lower audit quality. Of 857
auditor rotation (DROT), 714 rotations are voluntary and 143 are mandatory. Among 53 out of
857 rotations are pseudo (PSEUDO), 351 rotations are between Big 4 accounting firms (DBB),
62 rotations are from Big 4 to smaller accounting firms, and 75 rotations are from smaller
accounting firms to Big 4 ones. There are 430 rotations from a non-Big 4 to another non-Big 4
accounting firms during our study.

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Table 3: Regression results

Variables Beta t & F value Significance
Constant 0.175 12.191 0.000***
DROT -0.075 -1.909 0.057***
PSEUDO 0.007 0.127 0.899***
DBB -0.086 -3.942 0.000***
DBK -0.066 -1.694 0.091***
DKB -0.019 -0.433 0.665***
F 4.443 0.001***
Adjusted-R2 0.019
*, **, *** significance when alpha is 10%, 5%, and 1%, respectively.

The results in Table 3 indicate that the model has F-value 4.443 and statistically
significant with adjusted-R2 is 1.9%. The DROT is negative, marginally and statistically
significant. The negative and significant coefficient indicates that the discretionary accruals of
firms that mandatorily rotate their auditors is lower than that of voluntarily ones. Since lower
discretionary accruals means higher audit quality, we can conclude that firms that mandatorily
rotate their auditors have higher audit quality. This result supported the first hypothesis.
When the test is between pseudo mandatory rotation and others (PSEUDO), the result
indicates that no statistically significant difference between the earlier and the later. Insignificant
result tells us that neither pseudo mandatory rotation nor other types of rotation resulting in
higher audit quality. This is quite interesting since DROT variable indicates that mandatory
rotation is related to higher audit quality and we suspect that pseudo type of rotation will have a
lower audit quality. This result cannot corroborate our second hypothesis.
Moreover, our test provides some interesting evidences. First, discretionary accruals of
firms that switch between two Big 4 accounting firms (DBB) are statistically and significantly
lower than that of other switching firms. It indicates that audit quality of auditees that switch
from one of a Big 4 accounting firm to the other are higher than that of auditees that switch
between accounting firms of other types.
The same conclusion can also be drawn when we compare the discretionary accruals of
auditees that switch from a Big 4 accounting firm to a lower one (DBK) to other types of
switching. The coefficient is negative and statistically significant. It means that companies that
move from a bigger accounting firm to a smaller one have higher audit quality than that of other
companies that use other types of switching, but still not better than bigger to bigger switching.
In general, if we look at the coefficients, we can conclude that DBB type of switching has
the lowest discretionary accruals than DBK type. Above all, the DKK type of switching has the
largest value of discretionary accruals. Since we do not have a statistically significant coefficient
of DKB, we can only conclude that DBB type of switching has the highest audit quality,
following by DBK and DKK type of switching. These findings support out third hypothesis.

Fourth hypotheses
The interesting question related to the auditor rotation is why some accounting firms
“voluntarily and willingly” dissolve their firms and reform a new one, while still maintaining
their affiliation. The motive is obvious, i.e. to take advantage of the loopholes in the regulation
so that important clients are retained. This test is aimed to uncover the motives behind the
behavior of some accounting firms.

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Table 4: Distribution of rotating accounting firms

Year Pure mandatory Total Pseudo mandatory Total Voluntary Total Grand
rotation rotation total
Big 4 NonBig 4 Big 4 NonBig 4 Big 4 NonBig 4
2003 2 5 7 9 0 9 25 37 62 78
2004 1 2 3 4 4 8 17 56 73 84
2005 0 1 1 0 0 0 29 32 61 62
2006 0 0 0 0 1 1 44 41 85 86
2007 1 0 1 0 0 0 26 31 57 58
2008 0 1 1 0 0 0 8 29 37 38
2009 1 9 10 5 10 15 2 37 39 64
2010 0 2 22 9 5 14 46 29 75 91
2011 0 3 3 0 1 1 5 41 46 50
2012 1 1 2 0 0 0 20 29 49 51
2013 0 2 2 1 0 1 7 19 26 29
2014 0 0 0 0 1 1 5 39 44 45
2015 0 5 5 2 16 18 53 21 74 97
Total 6 31 37 30 38 68 287 441 728 833
(%) (16%) (84%) (5%) (44%) (56%) (8%) (39%) (61%) (87%) (100%)

Table 4 tells us that number of rotations occurred in 2017 are 97 rotations. Voluntary
rotations are on the highest type, i.e. 728 out of 833 rotations, followed by pseudo mandatory
rotations (68 rotations), and pure mandatory are the lowest (37 rotations). The table also
indicates that non-Big 4 accounting firms have a larger portion of rotating clients, i.e. 405
clients, while Big 4 accounting firms only audited 323 of them. Our samples of pure mandatory
rotations are dominated by non-Big 4’s clients, while pseudo mandatory rotations are slightly
dominated by non-Big 4’s clients. On the other side, voluntary rotations are also dominated by
non-Big 4’s clients.

Table 5: Financial characteristics of rotating companies (in billion rupiahs)

Characteristics Min Max Mean Std. Deviation
Assets Pure-mandatory 107 66,824 3,694 11,426
Pseudo-mandatory 63 111,774 7,857 18,899
Voluntary 0.567 242,392 4,448 14,789
Sales Pure-mandatory 13 22,324 1,730 4,074
Pseudo-mandatory 13 129,991 7,331 18,872
Voluntary (5) 184,196 3,065 10,050
Net income Pure-mandatory (64) 1,985 113 353
Pseudo-mandatory (2,110) 14,366 850 2,646
Voluntary (4,603) 15,489 218 1,204
Common stock Pure-mandatory 13 24,080 1,344 4,042
market value Pseudo-mandatory (3,766) 49,310 3,645 8,761
Voluntary (11,250) 102,043 1,749 6,276

Table 5 provides some financial characteristics of samples. Those characteristics may be

related to the motive of an accounting firm to engage in one of two types of mandatory
rotations.13 The mean value of all characteristics of pseudo rotation groups are the largest among
the other two groups. If we compare between pure mandatory versus voluntary rotations, we can
conclude that pure mandatory rotation group is the lowest among the three group. This fact is
interesting since, as Table 4 shows, more auditees belong to pseudo mandatory group than pure
mandatory one. Even though the largest portion of our samples belong to voluntary group, the
                                                                 
13
We cannot certain which client that has become the motive for an accounting firm to take the dissolve-and-reform
action. One indication may be when a certain client has reached its six-year limit before the accounting firm dissolve
and reform itself. This problem of identification may become our weaknesses.

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pseudo mandatory rotation group in average has the highest value from each of financial
characteristics observed.
We then test groups in pair and the summary of the results are presented in Table 6
below:

Table 6: Independent sample t-test results

Characteristics p-value
Assets Mandatory vs. voluntary 0.217***
Pure vs. pseudo 0.224***
Pseudo vs. voluntary 0.152***
Pure vs. voluntary 0.760***
Sales Mandatory vs. voluntary 0.146***
Pure vs. pseudo 0.021***
Pseudo vs. voluntary 0.070***
Pure vs. voluntary 0.422***
Net income Mandatory vs. voluntary 0.087***
Pure vs. pseudo 0.027***
Pseudo vs. voluntary 0.055***
Pure vs. voluntary 0.598***
Common stock Mandatory vs. voluntary 0.160***
market value Pure vs. pseudo 0.069***
Pseudo vs. voluntary 0.085***
Pure vs. voluntary 0.698***
*, **, *** significance when alpha is 10%, 5%, and 1%, respectively.

The results of independent sample t-test presented in Table 6 show that we cannot find
statistical differences between mandatory and voluntary group based on all financial
characteristics tested, except for net income. When using net income, it indicates that there is a
marginal statistical difference between mandatory versus voluntary groups. We also cannot
provide evidence that, in terms of assets, those groups are of different size. Therefore, we can
conclude that assets may not be a factor for choosing type of rotation, especially between pure
and pseudo mandatory rotations.
The interesting findings are statistically and significantly different between pure versus
pseudo mandatory rotation. Sales, net income, and common stock market value between
companies of those groups may become factors for accounting firms to choose whether to
dissolve and reform their accounting firms or not. The results imply that auditees with high sales
or net income or common stock market value may trigger an incumbent accounting firm to
dissolve the firm and, then, form a new one, so such firm can keep one or more auditees as their
clients for another six years. Logically, auditees with huge net income can pay more auditing
fees than one with lower net income. Client with a deep pocket is worthy to be kept, even the
accounting firm has to dissolve their firm before re-forming a new one. One indication of such
action is by looking at the foreign affiliation of accounting firm.14

Conclusion and future research

This research is based on the idea of whether mandatory auditor rotation will result in higher
audit quality. The Indonesian government enacted the regulation to mandate auditor rotation in
                                                                 
14
As example, INCO was audited by Hadi Sutanto and partners from 1999-2003 (five years). According the
regulation, INCO must change its auditor from 2004. In fact, the auditor change to Haryanto Sahari and partners.
However, both accounting firms were affiliated with PWC.

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2002 which since then mandatory rotation seems to be an accepted practice in Indonesia.
However, the reality is that accounting firms found their own way to deceive the regulation of
mandatory rotation. In a newspaper published in 2015, a senior auditor in Indonesia15 stated that
changing accounting firm’s name, and changing partners, including to set some partners to be
inactive partners of the firm or recruiting new partners are strategies used to take advantage of
the loopholes in the regulation. The motive is unstated, but public can guess as it is related to
accounting firm’s sustainable income. By applying that strategy, an accounting firm can keep
one or more important, deep pocket clients with them as long as they wish. Instead of changing
its auditor after the sixth year, the company is still the auditee of the old accounting firm since
the (local) auditor has “changed”—even though the foreign affiliation is still the same— and no
regulation has been violated. This is what we call as pseudo mandatory auditor rotation.
Our study finds that auditees in this pseudo mandatory rotation group have higher sales,
net income, and market value of common stocks than that of auditees in pure mandatory rotation
group. This finding confirms our hypothesis. Financial motives seem to be behind the choice of
the auditor to dissolve and reform the firm itself though competition among accounting firms and
small number of deep pocket clients have urged accounting firms to find a way to maintain their
income. If the idea behind the mandatory rotation is to preserve auditor independency after a
long auditor-client relationship, then the question of the effectiveness of such regulation is
important.
Our test of the first hypothesis confirms that companies which belong to mandatory
rotation group have higher audit quality than that of other groups. We, then, test the audit quality
of companies that belong to pseudo mandatory rotation and we cannot find a corroborative
evidence which pseudo mandatory rotation companies have higher audit quality than others.
When we test on the differences of audit quality of companies that switching accounting firms
from same or different sizes, the results indicate that audit qualities of auditees the switch
between Big 4 accounting firms are higher than that of auditees that switch between accounting
firms of different size. The higher discretionary accruals or the lowest audit quality is found
among samples that move between smaller accounting firms. These latter findings give empirical
support to previous studies back to the work of DeAngelo (1981) earlier that higher audit quality
is related to bigger accounting firm.
The main limitation of our studies is related to the measurement of the audit quality. A
qualified audit, by definition, is an audit performed by a competent and independent auditor
(DeAngelo, 1981). We choose discretionary accruals as the measurement of audit quality while,
in fact, known as measurement of earnings management. We base our logic on the idea that a
good auditor will find an abnormal accruals (i.e. equals to competence) and will not allow those
abnormal accruals to be included in the audited financial statement (i.e. equals to independence).
Further studies may consider other alternatives to measure audit quality.
The second limitation is related to the timing of measuring audit quality. In this study, we
only observe audit quality at the time of the switching. This is contrary to common belief that the
first years of audit is associated with higher audit risk. Future research may consider to use
longer time period to measure audit quality of single sample.
Future studies should explore the reason behind strategies used by accounting firm even
more. We limit our attention only on the financial aspects, while non-financial factors may play
some parts. For example, key persons in both corporations may influence the decision. We also
                                                                 
15
Business Indonesia, May 12, 2015. The article was retrieved from
http://starbrainindonesia.com/berita/media/40971/3/rotasi-audit-dihapus-kap-bakal-menggelia on May 29, 2017.

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do not explore which client(s), among some, that drive such behavior. The last important aspect
future research must consider is the fact that all local accounting firms that are affiliated with Big
4 accounting have chosen the dissolve and reform strategy, so the classification of pseudo or
pure rotation may need to be reconsidered in the future.

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